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Guide to
taking the tax free lump sum

Whether to take a tax free Lump Sum

Under current pension legislation in the UK, you are allowed to take a tax
free lump sum from your pension scheme of up to one quarter of your pension pot,
when you retire.

Since April 2015 you have full access to your pension fund from age 55 and
are able to take money out in whole or in part, although you will need to
understand the tax implications of doing this,

Whether or not you should consider taking a tax free lump sum, or additional
sums, is a decision that you
need to think about carefully, as taking it will affect your income in the
future. It also depends upon your personal circumstances and what type of
pension you have.

This guide can help you think about your choices but it is not advice, and
isn't tailored to your individual needs. If you feel you need to talk about your
options and what best suits your personal circumstances find an Independent
Financial Adviser or Chartered Financial Planner in your area.

This article is also based on current UK law and tax system.

What are you giving up by taking the cash?

Although the cash is tax free, it is not completely free cash! By selecting
it, you have to give up future income from your pension. For people in a Final
Salary / Defined Benefit Scheme, that means giving up part of a guaranteed
income for life for a cash sum now. As none of us know how long we will live,
you can't be sure whether you will be better off taking the cash now or having
the additional lifetime income.

For that reason (because you can't predict how long you'll live) you have to
think seriously about how much of your pension you want give up for a tax-free
lump sum.

Is taking the tax free cash a sensible thing to do?

There are two main decision areas:

If you need a cash sum to satisfy another objective (for example paying
off some or all of a mortgage, or going on a world cruise,
or providing a contingency fund if you don't already
have one), then taking the tax free cash sum
may be sensible.

Equally, if you are in poor health and do not have a long life expectancy,
then taking the tax free sum whilst you are still able to enjoy it makes
sense.

However, if you do not require a cash lump sum and just want to maximise
your income, then you need to think carefully. Essentially you will be
trading a guaranteed income in the hope that you can achieve better returns
from your own investment strategy with an associated (higher) level of
risk.

What are you giving up?

You might think that if you took your cash lump sum and simply bought a
pension with it (for example by buying an annuity), you would get the same
income as you have given up in your pension scheme. But it isn't that simple! It
depends on what kind of pension you have.

There are two basically two kinds of pension schemes: those where you build
up an amount of pension based on your earnings throughout your working life
(these are defined benefit schemes or 'final salary schemes'), or schemes
where you build up a fund of money and then use that accumulated fund to buy an
income when you retire (these are called defined contribution or money purchase
schemes). The decision of whether or not to take tax free cash is different in
each of these two types of scheme.

Taking cash in Defined Contribution/Money purchase schemes

For money purchase schemes it is relatively simple. You have a fund of money
which you can convert into a pension income when you retire, so on average,
taking the tax free cash should be a reasonable deal, as you get the tax break
by taking a cash sum ‘tax free’. So your decision is mainly around the two areas
identified above.

Taking cash from a Final Salary Scheme

These schemes pay you a pension when you retire based on a formula involving
your salary (either your final salary or your career average salary). That means
that there is no "pot" of money that you can take your tax free cash from,
instead you receive a ‘promise to pay’ a future retirement income from the
Trustees of the Scheme!

As a result, instead of simply taking 25% of your ‘fund’, you have to
"commute" your future pension income into an immediate cash sum. The problem is
that there is no guarantee that the "commutation rate" will recompense you
fairly for the amount of income you would expect to receive (on average) from
the scheme in the future - it will usually be less. This means that (ignoring
tax) for most Final Salary Schemes the tax free cash you get is less than the
amount it would cost you to replace the pension "commuted" from somewhere else!

Even though the cash is "tax free" it still doesn't mean it's a good deal.
You might still expect to get much more in the long run by taking it as pension
instead of cash, however it all depends on the "commutation rate" set by the
scheme.

This is a complicated calculation. The only way for most people to work
through this is to take independent advice.

Taking cash if you plan to go into income drawdown

There is one important exception to the above 2 general rules.

If you have a Money Purchase Pension and plan to take income drawdown, then
it may well be advantageous to consider taking the tax free cash sum.

With income drawdown, instead of buying a ‘guaranteed income’ in the form of
an annuity from an insurance company you leave your fund invested and simply
take money from the fund. This is a riskier option than simply buying an annuity.
In the past it was generally considered as something done by the wealthy or the financially
sophisticated. It was generally considered that you also
need a pension pot of at least £150,000 to require the sophistication of income
drawdown and outweigh the costs involved. However since April 2015 and the
introduction of 'Pension Freedom' no minimum income requirement
applies under flexible drawdown, as it did in the past, with drawdown subject to the
individual's marginal rate of tax. From the same date 'guidance' is
available to all
individuals with DC pension pots, see the
https://www.pensionwise.gov.uk/
web site.

If you are going to take income drawdown, one of your key objectives may well
be to maximise tax efficiency. If you take tax free cash, you not only get the
benefit of paying no tax on the amount withdrawn, but you may also be able to invest the majority of
the tax free lump sum (over a few years) into tax efficient vehicles such as
ISA’s.

However if that option is not available to you (for example you have already
planned to maximise your ISA allowances each year by using your existing
savings) then you will have to invest that money to generate a future income
that will be subject to both income tax and capital gains tax.

This is a situation where you definitely should take independent advice which
will be tailored to your individual circumstances.

Additional Voluntary Contributions (AVCs)

You may have increased your pension benefits by
personally paying into either an Additional Voluntary Contribution (AVC)
arrangement run by your scheme trustees, or a Free Standing AVC.

The majority of these additional schemes are money
purchase or defined contribution schemes (as opposed to final salary or defined
benefit schemes), which means that your contributions are invested, usually with
an insurance company, to build up a fund.

An AVC arrangement run through your employer's
pension scheme is known as an 'in-house' AVC scheme. The employer normally bears
the cost of administration of this scheme and so costs tend to be lower than
topping up pensions through other means.

An AVC linked to a company scheme is subject to the
rules of the main pension. When you claim payment of your pension, you are
entitled to take part of your pension benefits as a one-off tax-free cash lump
sum. You can use your AVCs to provide your tax-free cash lump sum entitlement
and avoid you having to convert as much of your main Scheme benefits.

The maximum cash you can take is 25% of the value
of your pension benefits, including any AVCs.

Added Years

Some schemes allow you to buy added years (as
opposed to AVC’s), which enable you to increase the number of years of service
you have in your main scheme. The added year’s purchased, boost both the amount
of pension that you will receive and your tax-free cash allowance, irrespective
of when you started contributing.

Free Standing AVCs (FSAVCs)

As an alternative to an AVC, or Added Years, it may
be possible for you to pay into a FSAVC arrangement. This is similar to a money
purchase AVC but is provided by external providers.

From an FSAVC you can take up to 25% as a Pension
Commencement Lump Sum which is currently tax free.

Cashing in an entire AVC
or FSAVC

Individuals able to demonstrate that they have a secure pension income for
life of at least £20,000 a year, otherwise known as the Minimum Income
Requirement, will have full access to their drawdown funds without any annual
cap.

All withdrawals from drawdown funds will be subject to tax as pension income.

If your total ‘secure’ pension income is in excess of £20,000 per annum from
the state pensions and your main pension scheme/s then you are allowed to cash
in the whole of your AVC/FSAVC fund. However only 25% of this is tax free, the
remainder would be taxed at your highest rate of income tax.

From a FSAVC you can take up to 25% as a Pension Commencement Lump Sum which
is currently tax free. An AVC linked to a company scheme is subject to the rules
of the main pension and so it may be possible to take the whole amount as a tax
free lump sum, as long as you do not exceed the maximum allowable amount, when
aggregated with your main scheme benefits.

Trivial Commutation or Trivial Lump Sum

You may be able to take the whole of your pension as cash, whether or not it
is Defined Benefit, or Defined Contribution. See details on the cash lump sum
page on the
Pension Advisory Service web site

Conclusion

Taking a tax free pension cash sum can make sense. It is tax free and you can
use the money straight away.

However it is not an easy decision and you should consider carefully whether
you need the cash now and can afford to give up the future income, or whether
leaving the money within the pension scheme will provide you with much better,
long term, value for money.